ETFs Explained: Beyond the Basket of Securities

An ETF is structured a bit differently compared to others in the space. From it’s first days in the market to present day, one can still see the ETF’s impact on the finance industry. Ron Delegge, the founder of ETFguide, joins Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers to discuss the main points about the foundations of ETFs.

Summary – Cents of Security Podcasts Ep. 25

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement 

Welcome back to the Cents of Security podcast. I’m Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers. Today, I’m your host for our podcast and our guest is Ron DeLegge, the founder of ETF Guide. We’re going to talk about the basics of ETFs. This investment product is structured a little bit differently compared to others in the space and from its first days in the market to present day, one can see that the ETF industry impact and the investor curiosity of the product has been seen. So welcome to the program, Ron. 

Ron DeLegge 

Cassidy, it’s great to be here and thank you for the invitation. 

Cassidy Clement 

Of course. So how about you give our listeners a little bit of your background in the industry? 

Ron DeLegge 

Well, I started in the mid 90s in the financial services industry as a stockbroker. That’s what we were called back in the day. And I had a Series 7 license and I did that for a while, about eleven years. I had my own RAA practice and then I decided to focus more of my efforts on education surrounding ETFs. So around that time I had launched the ETF Guide, this was in the early 2000s. Just sort of as a blog, and since then we’ve added original programming to our lineup, as well as tools for investors. And I’m also a certified retirement counselor- that’s part of the International Foundation of Retirement Education. So I do know a little bit about retirement planning and some of the things facing our generation of investors. So that’s sort of my background in the nutshell. 

Cassidy Clement 

Great. Well, it sounds like you’ll be the right person to ask some of these questions to. So for people who are just getting exposed to investing, what exactly is an ETF and how is it structured compared to the other financial products that most people are familiar with? Meaning the standard issue stocks and bonds. 

Ron DeLegge 

Yeah. So ETFs- I remember back in the day, this always used to get confused with EFT, electronic funds transfer. People would swap those words. But now ETF has become quite common and better known among the investing public. And it’s actually an acronym for ‘exchange traded fund’. ETFs are usually diversified investments that will own a basket of securities like stocks or bonds. But today, many ETFs are actually undiversified and concentrated because they’ll own a single asset. For example, like oil futures contracts or perhaps Bitcoin futures contracts. And now we’ve got a new generation of ETFs that may even own individual stocks like Apple or NVIDIA. So ETFs are quite diverse in what they offer as far as market exposure, but they’re definitely opening up a lot of opportunities for everyday investors. 

Cassidy Clement 

So they can be comprised of different types of other products, but it’s kind of I guess, like you said, a basket that’s diversified of some other things that would be in a normal portfolio or pool of investments that everyone can get access to from investing in that one ETF, instead of putting it together themselves. Is that correct? 

Ron DeLegge 

Yeah. So you’ve got a couple of different ways you can swing it. Some ETFs will actually own other ETFs, like a fund-to-fund approach, and that’s sort of like an all-in-one solution for investors that maybe want to have a pre-built portfolio. 

And they even have what’s called Target Date ETF portfolios that are designed to help you with a certain retirement target date. But then, like I was saying, you also have other ETFs which are a little bit more concentrated in nature, a little bit more focused. You’ve got sector ETFs for example, that only invest in specific industry groups like technology stocks or telecom or utilities. So there’s a lot of choices and a lot of things to think about. Sometimes when I look at the ETF industry compared to how it first started, there’s so many choices, Cassidy. Sometimes I get choice anxiety. You know, it could be really overwhelming. But again, it’s good that investors are listening to this podcast and gaining that knowledge and education before they dive in. 

Cassidy Clement 

So where exactly or when exactly did ETFs kind of come into the market? Like, what is their origin? Because as long as I’ve been exposed to financial trading and markets, I’ve always heard of them. And I also have had the confusion of EFT and ETF, but I’ve always been familiar with them. So when exactly did they hit the scene and how did it go? 

Ron DeLegge 

Yeah. So actually, ETFs first debuted in 1990 in Canada, and it’s interesting- you got to hand Canada some props because they not only came up with the first ETF, but they also came up with the first Bitcoin. Spot Bitcoin ETF, which was launched in, I believe it was 2021. But 1990 was the official launch date of ETFs, as it’s known. Shortly thereafter, in 1993, the Spider ETFs which are linked to the S&P 500 Equity Index debuted here in the US. 

And that became the very first US-listed ETF. Now in the early days, ETF investing was mostly limited to large institutions and money managers and sophisticated, big pension funds, multibillion dollar pension funds. But over time, what we’ve seen is the ETF industry investor base and demographics have really changed and it’s greatly expanded and now includes RAAs, wealth advisors and even self-directed retail investors. 

Cassidy Clement 

So with all of those pieces of people getting in from, let’s say, all angles. We’re talking, like you said, retail investors, not just the money managers, it’s not just the institutions; what type of impact was this having on the finance industry when it first entered and how it is now? Because it seems like it’s another product for, of course diversification. But it’s also to help with managing your risk, having something a little bit more passive than you managing it all the time yourself or having to pay someone to manage it at all times, like how exactly did it impact the industry? 

Ron DeLegge 

Well, it’s given the industry more opportunities to offer their asset management services and another product format. This year the big trend in 2023 has been mutual fund companies either converting existing mutual funds share class to an ETF structure or even launching cloned ETFs, which basically mimic existing strategies.  

So we’re seeing a lot of active managers getting into the business offering active ETF solutions. So definitely the asset management industry has had more opportunities to appeal to a new demographic of investors. I think about the early days of ETFs and getting back to to when ETFs were still making a name for themselves. I mean, this was a pretty controversial type of investment, much more so than what it is today. It has become mainstream. 

But you know, critics back in the early days.. there were some pretty loud critics of ETFs. You had Vanguard’s founder, John Bogle, who was one of the biggest critics at the time. This was right as Vanguard was about to launch its own ETF lineup. They had not yet gotten into the ETF business and there was a lot of internal debate whether they would do that or whether they shouldn’t. And so here you had the founder, John Bogle, a proponent of mutual funds and indexing.  

His problem with ETFs, he claimed that, well, they’re going to become day traders, you know. We’re going to take all these long-term investors and they become day traders. And so, what these critics did not understand or see is that ETFs actually appealed to both short-term and long-term investors. And that unlike mutual funds, active ETF trading by one set of shareholders of the same fund would have no negative tax or cost implications on another set of shareholders of the same ETF. 

So, even today when you think about it, ETFs are just so unique because you can have shareholders of the exact same fund with opposite goals. A shareholder might be using the ETF as a short-term vehicle, maybe a portfolio placeholder, whereas another shareholder might be using the same ETF for completely different goal. And this is something that’s radically changed the mindset of the finance industry because historically, shareholders flock to a fund because they have the same goal. With ETFs, it’s not necessarily the case. So that’s just due to the unique structure of the ETF itself. It’s greatly improved the way investors allocate money.  

I think, because like I said, just from this example, one shareholder, whatever they do, if they want to trade daily, that’s fine. But whatever they do is never going to impact another shareholder. And I think that’s a beautiful thing that’s unique to the ETF structure. And it’s really a truly fair and democratic approach as opposed to me holding a fund and then my activity impacting shareholders that remain.  

One final thing, sorry for the long-winded answer here too, Cassidy. The other thing I will say that ETFs have done.. getting back to your question about how has this impacted the finance industry.. is they’ve really opened up and broken through the asset class universe.  

They’ve made it easy for investors to obtain market exposure to nearly every asset class you can think of with a very low degree of cost. And also they’ve overcome these obstacles of difficulty. For example investors don’t need to own a farm or a futures brokerage account to get exposure to commodities. They can just use commodity ETFs to get their exposure. And there’s many other examples. We see cryptocurrencies are just beginning to open up. Again, the ETF structure allows investors to keep that brokerage account. If that ETF follows that certain asset class, they can get that exposure with that ETF. So again, these are just examples of ETFs breaking up breaking open brand new asset classes and allowing investors to gain diversified exposure, which is a good thing. 

Cassidy Clement 

So I’m just asking this from the perspective of somebody just taking a look at some investment products, but if you were to explain at least just briefly the difference between what a mutual fund is and an ETF? Just so listeners don’t have any overlap because I know when I was studying for the Series 7 that sometimes it’s hard because a lot.  

Some ETFs are similar to mutual funds and some of them well, you do have pulled investments, but some have the buy and sell feature throughout the day. If you could just give a little explanation so we don’t confuse the listeners. 

Ron DeLegge 

Yeah, I mean, the main difference here, we don’t want to over complicate things. Mutual funds and ETFs are cousins. They’re both related to each other. So they’re similar in nature in many aspects. I mean, the main difference is obviously a mutual fund only trades once a day and you’re going to buy it or sell it at its net asset value, also known as NAV.  

Whereas an ETF, it trades throughout the day, so as long as the markets open for business, you’re going to see an ETF have trading volume. You can buy it and sell it just like an individual stock, right? And that’s what we call intraday liquidity. That’s the fancy, fancy language. And that’s really the main difference- that intraday liquidity that you get with ETFs. You don’t have intraday liquidity with mutual funds. You have to wait till the end of the day and you don’t really know what the price is going to be, so you lose some flexibility, I think, when it comes to determining when you’re going to buy and what price you’re going to buy at and what price you’re going to sell at.  

I think that’s a big disadvantage for the mutual fund shareholder that doesn’t really get discussed a lot, but again, I like to buy.. Personally, when I go into a store, I like to know what the price tag is before I buy it. And so I think investors should just keep that in mind. But ETFs and mutual funds overlap in many different asset classes.  

And you even have some firms that will offer a mutual fund and an ETFs for the same exact index or asset class. And they do that again just for convenience, because some investors may still be using a mutual fund in their investments. Like for example, if it’s a 401K retirement plan or something of that nature, there may not be an ETF choice. But I think looking ahead, it’s my hope and I’m really a big proponent of ETFs inside retirement plans, I think that’s the one place where the ETF industry is still missing in a big way.  

They haven’t really been players in the 401K marketplace, but I think that’s going to change in the future. I think you’re going to start seeing ETFs right alongside mutual funds in 401K plans, 403B plans. It’s going to become more commonplace as the ETF industry matures.  

Let’s not forget, too, Cassidy, the mutual fund industry is going to be 100 years old next year. So the first mutual fund was launched in 1924. Think about that. ETFs just celebrated their 30-year anniversary earlier this year. So you’ve got an ETF product that’s only 30 years old versus a mutual fund product which is 100. So that’s a big difference in terms of age. So obviously mutual funds are a lot more mature. ETFs are still catching up, but we’ve seen tremendous asset growth. The ETF industry is around $7 trillion. So they’ve grown very fast in such a short time. And eventually some are predicting that ETF assets will eventually surpass mutual funds. And I think that will happen only if ETFs become more commonplace in 401K retirement plans. But that’s something that is to be determined and maybe a good topic for a future conversation. 

Cassidy Clement 

Yeah, I was going to say that in and of itself could be its own podcast probably. But you actually had mentioned something I totally forgot about. I had a flashback to my Finance 101 exam when I heard intraday versus interday.  

Oh my gosh, remembering and keeping those things separate. Oh my goodness. So totally for those of you out there who are studying for your finance exam with ETFs versus mutual funds, I sympathize with you. Make the bullet lists for them to remind yourself of the differences because it sometimes gets to be hard to keep up.  

But for the investors entering the ETF space who are just starting out and there’s a lot of things to synthesize, and of course, as everybody knows who does their own investment research, there are so many research points out there. So what are some things that investors should look for when starting to scope out a new investment opportunity in the ETF space? 

Ron DeLegge 

Well, I think before you even start looking at ETFs, investors first need to understand what are my goals? What am I after? What am I trying to achieve? And that gets back to something called a written document that’s called an ‘investment policy statement’, and it sounds a lot fancier than it really is.  

It just explains what you, as an investor, what your goal is. What is going to be your target asset, asset mix, what is your time horizon for investing? What are the types of investments that you’re going to use to reach your goals? What are the types of investments you’re going to avoid? And if you’re working with a financial advisor or RAA, what are the fees? What are the fees that you’re going to be paying to them? And you can also set limits like I won’t pay more than X amount.  

So investors have a lot of choices to make. But I think it really begins before you even start talking about ETFs or anything for that matter, it begins with having a solid understanding of what your goals are. So that’s the investment policy statement and all investors should have that. If you’re working with an advisor, most advisors will supply you with that. But even if you’re a self-directed investor making your own choices you should still have something that’s written that dictates what your portfolio will be.  

And then after you’ve done that, then you can get into what your framework for building an investment portfolio is. I think about it like architecture of a building. Like before you start building that structure, you got to have an understanding of what is the blueprint, right? What are the materials that are going to be used? How many stories is that building going to be? And the basics of what the architecture is going to be.  

So for the portfolio, an investor using ETFs will want to start there and then build out that portfolio. Usually you start with something called a ‘core’. So core is usually broadly diversified funds that give you asset class exposure to the core asset classes like stocks, bonds, commodities and real estate. Those are the big four. And then cash. And once you build out the core, that’s your foundation, then you can add other elements what are known as supplementary or pieces of that portfolio that kind of accentuate your core and maybe allow you to personalize your portfolio a little bit more.  

Maybe you want to emphasize certain themes, whether that be certain movement or trend in the business world. You can find ETFs for that. So again, start with the good core. Also, I encourage investors to always have what I call a ‘margin of safety’ or ‘cushion’ to make sure that you’re able to have that safety liquidity.  

And also, principal protection, I think that’s a real core and important part of the portfolio. So again, these are all things to think about even before you buy your first ETF. Just to have an understanding of of what the goal is and how you’re going to build this portfolio. You’re really the architect of a building. It’s your financial house, so you need to have some thought before you start buying the bits and pieces of that house. 

Cassidy Clement 

Yeah, I mean, I always thought of ETFs.. I know they call it a ‘basket of securities’, but I always kind of thought of it like you’re going through the supermarket. Which then I guess is a direct metaphor for the stock market. And you’re putting items into the basket and you want to make sure that you understand how well the item is going to perform, what’s it made of, how much is it going to cost you both now and later if you have to sell it, things like that. And understanding if you’re going for something trendy aren’t always permanent. So like you said, making sure you understand you may need a cushion or something like that if your investment isn’t perfect, which no investments are.  

But what are some well-known ETFs or important ETFs that listeners may be familiar with that they’ve heard in the space of financial media and journalism? 

Ron DeLegge 

Yeah, I mean, the big ones that you hear about on a daily basis are like the triple Qs. I mean the ETFs that dominate trading volume are the ones that get the most attention. Triple Qs are an example which are linked to the NASDAQ 100, the Spider S&P 500 ETF, which we discussed earlier. That was the first ETF ever launched here in the US, just celebrated a 30-year anniversary. So these are some well-known ETFs.  

The one thing I will say is just because it’s well known or heavily traded does not necessarily mean it’s right for you. So there’s a lot of ETFs that are actually more obscure in nature that that are actually quite good, that, again, investors can use a platform like Interactive Brokers to look at some of the research that’s available out there and do some digging.  

Do some digging and find those gems, because there’s some real good gems out there that that may help you to accentuate your portfolio, embellish it, get it to where you want. Your portfolio, it constantly, things are constantly changing. You alluded to it, you know about trends, things are constantly changing. And so just because you build a portfolio doesn’t mean you’re done. There’s always tweaks, there’s always rebalancing. There’s always adjustments that need to be made.  

I mean we can use another analogy. I’m not much of a sailor personally, but I do paddle board. And so when I go out there and I go on the ocean and paddle board, conditions are constantly fluctuating. The ocean is never just flat. And some days, they’re just flat and it’s like ice skating. It’s like beautiful. But then other days it could be choppy. So you have to constantly adjust- conditions in the market change very quickly. So I think investors need to be ready and flexible and be adapting. 

Cassidy Clement 

Yeah, I mean thinking about investment, when you talk to people who maybe do it for a living or have been doing it for a long time, most will say it’s not a ‘set it and forget it game’. You have to adjust, you have to be aware and you have to be ready to potentially have a reaction if one of your investments is against the trend or with the trend, you never know.  

Ron DeLegge 

True.  

One thing I will say if I can just add, I think it doesn’t get discussed very much, but I see this with some of the portfolios that that I’ve seen from ETF investors, There’s a tendency to over diversify. In other words, investors will sometimes own too much of the same thing. So, ETFs with a different ticker symbol. But if you look at the underlying holdings, they’re almost identical. They own the usual suspects, Apple, Amazon, Google. And even though it’s a different ticker symbol and it looks different on your portfolio screen, actually you may own a lot of the same thing. 

And that’s something called ‘over diversification’, which is like diluting your soup. No one wants to eat diluted soup. You want soup that has good flavor to it. It’s it’s not overwhelming, but it hits the right spot. And so I think with your investments, you want to think about it from that perspective. You don’t want to over diversify and dilute your efforts or even increase your risk unbeknownst to you. If you own too much of the same stuff and that same stuff is sinking, owning more of it is not going to help you. 

Cassidy Clement 

Right. Diversifying to diversify what you diversified with can sometimes come back around. So it can all be cyclical or you end up with the same thing, so when one domino falls the rest of them do. Yeah, there’s a chance you can confuse yourself. 

But you brought up some really great points about ways to get into the ETF space, what they’re all about and those initial questions that somebody might have as they start to investigate. Thanks so much for joining us. 

Ron DeLegge 

Cassidy, it was fun. Thank you for having me and I hope we catch up again. 

Cassidy Clement 

Of course. So as always, listeners can learn more about an array of financial topics for free at ibkrcampus.com, follow us on your favorite podcast network, and feel free to leave us a review or a rating. Thanks for listening, everyone.